Demonetisation: Surgical strike or carpet bomb

Nov 20, 2016 • Hemant Kumar

At 8pm on the 8th of November prime minister Narendra Modi announced that from midnight all 500-rupee and 1,000-rupee notes would cease to be legal tender. This deliberate shock demonetisation policy was announced with the following 3 main objectives:

Removal of counterfeit currency

Stamping out black money

Move towards a cashless economy

This was a bold move as a surprise of this nature is meant to disrupt an economy in which 90% of all transactions are conducted in cash and the two cancelled notes account for 86% of all the currency in circulation. This was both economically and politically a risky move . The prime minister even had to make an emotional plea to the nation to back him and stick with the hardships caused by demonetisation for 50 days. In the past couple of weeks there has been a lot of anguish and distress amongst the general public with hours of queues outside banks and even deaths being reported.

The media has called this a surgical strike on black money and corruption. Is this really a game changer that will get rid of the black money and corruption in India or are we paying too high a price for a supposedly elusive benefit? Let’s begin by looking closely at the three objectives individually.

Removal of counterfeit currency

Benefit: Funding for terror and other subversive activities in counterfeit currency will be removed.

Does demonetisation achieve removal of counterfeit currency? Yes! Was this the only way of going about doing this? No! A phased out release of new currency would have achieved the same objective without starting a panic that we are seeing today in the financial system. A lot of countries do this all the time in a managed way, by introducing redesigned bills to improve security of the currency. A shock to the system or the so called surgical strike does mean less time for the counterfeiters to move their money around but it also means giving less time to genuine traders and small time businesses to get on with their daily trade. That is why we are seeing a lot of disruption to in the unorganised economy.

Stamping out of black money

Benefit: Approximately $14 to $44 billion of back money will be extinguished.

According to the Ministry of Finance 2012 report, roughly 6 percent of the total black money is held in cash. Large proportions of black money is invested in real estate or gold and most of all moved abroad. Only a fraction of the funds received from illicit tax evading activities is kept in cash. Therefore the amount recovered due to demonetisation is a very small proportion. Even the 6 percent might not be completely coming back into the banks as people who hold that cash could and are laundering their black money by paying anywhere between 10 to 30%. Although the shock therapy prevents hoarders from diverting their money quickly but the target is too small to fetch or remove the entire $14 to $44 billion.

Move towards a cashless economy

Benefit: Higher traceability of transactions, more businesses come under the tax net, higher revenues for government.

Did you imagine a chaiwala or a newspaper vendor getting paid via paytm? It is happening now, not because of choice but out of necessity. The shock therapy has definitely made people come up with innovative ideas to support their businesses as their livelihoods are at stake. This would not only widen tax collection as more transactions come under the tax net but prevent inaccurate invoicing by companies, under reporting of sales values and reporting non-existent transactions. However, this will take long and there will be a lot of pain in the interim especially in the rural economy until the new notes come into wider circulation. The two cancelled notes account for 86% of all the currency in circulation; over 90% of all transactions are conducted in cash, and over 85% of workers get their incomes in cash.

What happens next?

So is all the pain worth going through? The honest answer is we don’t know yet. A lot will depend on the follow up. There is little doubt about the sincerity of the move but the lack of planning and shoddy execution without thinking through the consequences has meant major disruption of the market economy. This has had an adverse impact on the unorganised sector which accounts for 40% of GDP and 80% of all employment, causing severe hardships especially for the casual daily wagers and farmers who depend solely on cash. Given the government wanted to go ahead with demonetisation, it could have in advance, infused a far greater number of 100-rupee notes into the economy and printed a greater quantity of 500-rupee and 2000-rupee notes to avoid some of this disruption and pain.

To think that a single surgical strike will end corruption and expunge all black money would be naive. In order to to remove the roots of corruption, what is needed is structural and fundamental reforms in the areas of major sources of corruption i.e, tax, real estate and political funding. Demonetisation is barely scratching the surface, if the follow up to it is a carpet bomb of reforms we may have a chance against corruption, otherwise precious time will continue to be wasted in debating the worth of this move while notebank politics continues.